To mitigate the drinking water crisis in Kathmandu city, the Government of Nepal has recently initiated the Melamchi project, which will divert water from the Melamchi River to Kathmandu city's water supply network. In the first phase, the project will divert 170,000 cubic metres of water per day (at 1.97 m 3/s). There is a plan to triple the volume of water using the same infrastructure as city water demand increases. This paper illustrates the complexities involved in planning and implementing the intersectoral (interbasin) water transfer project, and the socio-economic and hydrological implications of the project in the basin of water supply. This project potentially generates huge economic benefits, mostly accrued to the urban sector. An already a resource-poor water-supplying basin bears all the opportunity costs of the water transfer. The project compensation scheme has focused more on local public goods and has not much considered third party effects such as traditional water mill owners and tenant farmers who may unduly bear the brunt of the project. Effective participation of stakeholders and early negotiation for compensation could minimize such third party effects. The absence of such negotiation has raised some concerns about the effectiveness of the Melamchi project to meet the social obligations in the basin of water origin. © IWA Publishing 2005.